Fed cuts rate half-point

level lowest in 40 years

10th trim this year for federal funds rate aims to jolt economy

November 07, 2001|By Paul Adams | Paul Adams,SUN STAFF

Responding to a month of bleak economic news, Federal Reserve policy-makers cut a key U.S. interest rate for the 10th time this year, sending it to its lowest point in 40 years amid evidence that the economy slipped into a recession after the Sept. 11 terrorist attacks.

The Federal Open Market Committee cut the federal funds rate - the rate banks charge one another for overnight loans - a half-percentage point to 2 percent. The Fed also cut its discount rate, the rate that the Fed charges to make direct loans to banks, a half-percentage point, to 1.5 percent.

Policy-makers are hoping the new cut boosts flagging consumer spending and spurs businesses to invest after months of layoffs and dismal earnings. So far, the Fed's aggressive moves have done little to inspire an economy in a free fall amid fears of more terrorist attacks.

Economists were almost evenly divided over whether the Fed would implement a half-point reduction or opt for a more conservative quarter-point cut, which would have left more room for further reductions if the economy continues to sour.

Some fear that the Fed could lose its ability to control the economy if rates approach zero, as has occurred in Japan.

But most economists agreed that the economy would likely get worse in the fourth quarter, prompting one or more additional interest rate cuts over the next several months. Future cuts will probably be in the quarter-point range, economists said.

The last time the Fed cut interest rates 10 times was in 1991, just as the economy was beginning a record expansion that didn't abate until this year.

After the economy shrank 0.4 percent last quarter, economists now believe the economy has entered its first recession in a decade.

"Heightened uncertainty and concerns about a deterioration in business conditions both here and abroad are damping economic activity," the Fed said in a statement announcing its decision.

That seemed to confirm the likelihood of another cut when policy-makers meet next month, though some economists are questioning how much impact further action will have on consumer confidence and spending.

And there is division over whether the cuts, combined with a possible economic stimulus package being debated in Congress, could be too much of a good thing.

"I think we need a bona fide fiscal stimulus as well to go along with this rate cut," said Robert MacIntosh, vice president and bond fund manager for Eaton Vance Management. MacIntosh is skeptical that a rate cut will have much impact by itself.

"I think the market is becoming a little desensitized to the moves," said Joseph C. Cirelli, a financial consultant with Salomon Smith Barney in Baltimore. "The first time the Fed moved, the market moved 10 percent in one day, an unbelievable day."

The Nasdaq composite index rose 41.43, or 2.3 percent, to 1,835.08, erasing a 0.9 percent decline from before the Fed announcement. The Dow Jones industrial average gained 150.09, or 1.6 percent, to 9,591.12, its highest close since the Sept. 11 terrorist attacks.

The Standard & Poor's 500 index advanced 16.02, or 1.5 percent, to 1,118.86, with 10 of its 11 industry groups rising. More than 1.3 billion shares traded on the New York Stock Exchange, 12 percent above the three-month daily average

Major banks, including J.P. Morgan Chase & Co., the second-largest U.S. bank, and FleetBoston, lowered their prime lending rates - the rate they charge their best customers - by a half-point to 5 percent, effective today.

The cut means lower borrowing costs for consumers and corporations heading into the important holiday shopping season. Such consumer spending accounts for two-thirds of all economic activity.

Only one regional bank in the Fed system requested the half-percent cut, suggesting a majority of Fed bank presidents were comfortable with a quarter-point move, said Steven Wood, chief economist for FinancialOxygen Inc., an Internet banking services firm.

But Wood said Fed Chairman Alan Greenspan likely led the drive for bolder action, motivated in large part by last week's news that unemployment shot up a half-percent in October to 5.4 percent while consumer confidence plunged to a 7 1/2 -year low.

At the same time, consumer spending declined in September by the largest amount in almost 15 years and manufacturing activity plunged last month to its lowest level since 1991.

"He believes there's plenty of room yet to move," Wood said, "so the Fed's not running out of ammo by any means and the economic situation is dire enough at this stage that you had to do [a half-percent]. You've got to do a big statement."

Some economists expect the Fed to keep cutting rates over the next several months until the federal funds rate approaches 1 percent to 1.5 percent, roughly the level of inflation. At that rate, the real interest rate is effectively zero.

With rates that low, interest paid on certificates of deposit and other "safe" investments will decline to the point where investors who pulled out of the market will again buy stocks, helping to spur a recovery, some economists said.

However, economists don't expect to see a recovery until the middle of next year, provided there are no more surprises, such as another terrorist attack that could send consumer and business spending spiraling even further.

A strong recovery next year would likely force the Fed to reverse its monetary policy sharply in order to head off inflation. The Fed traditionally tries to avoid large swings in policy.

But these are not normal times.

"The last thing for the Fed to worry about is generating inflation because too much stimulus is sort of like worrying about getting your house wet when it's on fire," said Alan D. Levenson, chief economist for T. Rowe Price Associates Inc.